E2Open, the supply chain software provider that is going public through a merger with a special purpose acquisition company (SPAC), has been given a B rating on its new debt from S&P Global Ratings.
A B rating is not investment-grade. It is roughly halfway down the scale between the strongest non-investment grade rating of BB+ and the bottom rating. (The rating below that is D, which means a company has defaulted. The highest rating at S&P is AAA, carried by only two companies in the U.S., Microsoft and Johnson & Johnson.)
E2Open is being merged into a SPAC, CC Neuberger Principal Holdings. An existing public stock for the SPAC will instead have its name changed to reflect the E2Open merger. That will return E2Open to public equity markets where it was traded prior to an earlier acquisition by a private equity company. The debt being taken on to facilitate the deal is approximately $525 million.
Although the debt rating is not particularly strong, the report issued by S&P Global Ratings was mostly positive about the outlook for E2Open. S&P Global, like other debt ratings agencies, does not give opinions on the strength of a company’s stock or whether it should adopt a different strategy. It is interested in the company’s ability to cover its debt payments, which will be needed as the new entity will be taking on new debt to pay its prior investors.
S&P Global Ratings’ B rating also came with an outlook of “stable,” meaning a move upward or downward is not likely in the near future. That stable outlook is based on what S&P called E2Open’s “predictable and sticky subscription revenue streams.” It also notes that E2Open has “accelerating” growth opportunities, as much of the company’s growth in recent years has been through nonorganic acquisitions.
The metric used in part to reach the B rating is the company’s projected free cash flow relative to debt. S&P projects E2Open to have FCF of about $50 million, which will keep the company’s leverage at 5.5X or lower EBITDA over the next year.
Within the ratings report are observations about the supply chain software market that E2Open plays in. S&P described it as “a very competitive market” with competition from major players like Oracle. But the agency said “the mission-critical nature of its solutions, its high proportion of subscription revenue and its long-standing relationships with its diverse customer base helps mitigate these constraints.”
S&P appears to be critical of the company’s strategy of lots of acquisitions in recent years, saying that its nine deals since 2014 did “bolster its product offerings” but that it came “at the expense of investing heavily in its sales force.” But the ratings agency expects a shift. “Despite its muted organic revenue growth over this period, we believe E2Open is now better equipped to address the needs of customers that operate global supply chains due to its improved offerings,” it wrote in its report.
Cross-selling opportunities will be key to E2Open’s growth, with 50% of its current list of 1,300 customers buying only one product from the company, according to S&P.
But those sales don’t happen all that quickly, possibly taking a year to conclude and requiring “significant investment.” But overall, the outlook is good for the company, according to S&P. It notes that the supply chain management market is expected to grow “above mid-single digits” that can be combined with an improved portfolio from E2Open to produce “consistent growth.” “We forecast that its revenues will grow (a) high-single-digit percentage in fiscal 2022,” S&P writes.
In addition to assuming that E2Open will dial back its acquisition binge and instead focus on organic growth, S&P sees the fact that it will be a public company as providing guardrails of financial discipline. As a publicly traded entity, S&P said, E2Open will “adhere to its more moderate announced financial policies.” That includes getting its leverage down to 3-4X EBITDA.
The S&P Ratings report discloses several financial facts about E2Open that would have become public eventually when its stock begins trading. Among them:
— Its top 10 customers account for about 30% of its revenue, which S&P describes as a “modest customer concentration.”
— Its customers stick around with historically high gross retention rates exceeding 95%.
— Fiscal 2021 should record 8% growth in revenue, up to $330 million.
As is standard for when S&P Ratings puts out a rating on a company, it notes what might need to happen at the rated company that would lead to a higher or lower rating. A lower rating than B might ensue if E2Open’s “operating performance significantly underperforms our forecast” or if “more aggressive financial policies” are adopted that send the cash flow to debt ratio to move negatively.
But if leverage improves to less than 5X based on improving financials, an increase could be considered, S&P says.
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